hedge funds: a political and economic analysis · 2017. 10. 28. · hedge funds have the ability to...

ECONOMIA INTERNAZIONALE / INTERNATIONAL ECONOMICS 2017 – Volume 70, Issue 4 – November, 479-508

Authors::::

CAMERON J. GABLE, University of San Francisco, California, USA

SHALENDRA D. SHARMA, University of San Francisco, California, USA

HEDGE FUNDS: A POLITICAL AND ECONOMIC ANALYSIS

ABSTRACT

Hedge funds are indispensable to the modern day economy, but remain one of the most poorly

understood instruments of financial globalization. The financial crisis of 2007-2009 propagated

fallacious interpretations of the role of hedge funds in precipitating the crisis. In turn, this has

led to unsubstantiated policymaking. This paper seeks to clarify many of the misconceptions

surrounding hedge funds and elucidate their rise to prominence. It will be argued that the

excessive regulation of hedge funds is unnecessary and ultimately detrimental to the global

financial system. Governments can prudently utilize hedge funds because they have the

potential to reduce systemic risk and induce innovation.

Keywords: Alternative Investment Vehicles, Assets under Management (AUM), Capital Markets, Long-Term Capital

Management, 2007-2009 Financial Crisis

JEL Classification: G15, G21, F30, F38

RIASSUNTO

Gli hedge funds: un’analisi politica ed economica

Gli hedge funds sono indispensabili nella economia moderna, ma rimangono uno degli strumenti

di finanza globale meno compresi. La crisi finanziaria del 2007-2009 ha indotto interpretazioni

fallaci sul ruolo degli hedge funds nel far precipitare la crisi. Di conseguenza ciò ha portato a

decisioni politiche infondate. Questo studio cerca di chiarire molte incomprensioni che

riguardano gli hedge funds e di spiegare perché sono diventate così diffuse. Si argomenta che

l’eccessiva normazione degli hedge funds non è necessaria, anzi è addirittura dannosa per il

sistema finanziario globale. I governi possono utilizzare gli hedge funds prudentemente perché

sono potenzialmente in grado di ridurre il rischio sistemico.

480 C.J. Gable – S.D. Sharma

www.iei1946.it © 2017. Camera di Commercio di Genova

1. INTRODUCTION Hedge funds have become ubiquitous in today’s vernacular, but they remain one of the most

poorly understood instruments of financial globalization. The general public and the media

have become enamored with hedge funds because of their unprecedented ability to raise billions

of dollars in capital and profits within a short time frame. The media has systematically

developed a portrayal of hedge funds as an insidious creation of capitalism, which is responsible

for creating financial crises and rising inequalities in the advanced economies. Unfortunately,

such generalizations also propagate misconceptions about the nature and role of hedge funds,

including misguided policymaking. This paper provides a corrective by providing a more

nuanced view of hedge funds, its composition and functionality, its origins, and economic

effects, especially in the United States. Also addressed will be issues pertaining to “herding” and

the psychological attributes of managers, the role of hedge funds in the 1997 Asian financial

crisis, their disruptive effects in Europe, the role of hedge funds in the 2007-2009 financial

crisis, Germany and France’s attempts to heavily regulate the industry throughout the European

Union, the European Union’s Alternative Investment Fund Managers Directive (AIFMD), and

the effectiveness of other regulatory measures and their broader implications for the global

economy. The paper will conclude by making a case against imprudent regulations. It will be

argued that the excessive regulation of hedge funds is unnecessary and ultimately detrimental to

the global financial system.

2. COMPOSITION AND FUNCTIONALITY OF HEDGE FUNDS Hedge funds are highly complex private investment vehicles managed by professional managers

where investors pool their money to maximize positive returns (SEC, 2012). The objective of

hedge funds is to make money in both the bull and bear markets. The fund’s organizational

structure can generally be broken into two distinct components: the fund manager that manages

the money and the limited partners (also known as the investors) that provide the majority of

the fund’s capital. It is important to note that hedge funds are exempt from the Investment

Company Act of 1940 (Investment Company Institute, 2007). Hedge Funds primarily cater to

high net worth individuals and institutions where investors’ pool their money in order to invest

in multitudinous assets. The SEC has created a system of accreditation to determine who can

qualify to invest with a hedge fund. According to Eric Bank of Zacks,

Hedge funds: a political and economic analysis 481


“the SEC’s definition of accredited individuals include those with $1 million in net worth or those with

incomes exceeding $200,000 in each of the previous two years…” (Bank, 2011).

This system of accreditation was instituted to limit the number of people that qualify for

investing in hedge funds since they are highly risky investment vehicles.

Hedge funds have the ability to take both long and short positions and the assets that they

generally invest in include commodities, equities, derivatives, futures, bonds, securities, and

currencies (US Treasury, 2002 p. 19). Hedge funds are unique in the fact that they can thrive in

both liquid and illiquid markets. This flexibility has enabled them to engineer returns in bear

markets and minimize their risk. The average hedge fund manages about $40 million (referred

to as AUM or assets under management) and the largest hedge funds manage around $1 billion

(Wilson, 2010 p. 7). In addition, hedge funds are somewhat similar to mutual funds, both

structurally and functionally. However, hedge funds are distinct by the fact that they are not

widely accessible to the general public and are usually exempt from registering with the SEC or

other regulatory bodies (Managed Fund Association, 2014). The legendary fund manager,

George Soros, notes that,

“hedge funds engage in a variety of investment activities. They cater to sophisticated investors and are not

subject to regulations that apply to mutual funds geared toward the public. Fund managers are

compensated on the basis of performance rather than as a fixed percentage of assets” (Soros, 2000 p.

32). This is another important difference between hedge funds and mutual funds.

Hedge fund managers generally charge a 2 percent management fee and a 20 percent

performance fee (commonly referred to as the “Two and Twenty”). However, these fees can

range from 10 to 20 percent for performance fees and 1 to 2 percent for management fees

(Wilson, 2010 p. 5). The fee structure is an integral part of hedge funds and arguably contributes

to the viability of the fund. Most managers pool their own money into the fund, which they use

for investment and speculation. This creates a powerful incentive to actively engage in risk-

aversion to avoid losses. Hedge funds have also developed sophisticated mechanisms to provide

additional reassurance to investors since they often engage in risky trading strategies. Some of

these mechanisms include the so-called “hurdle rate,” which is



“… a performance figure that must be achieved before any performance fees will be calculated or paid to

the hedge fund manager” (Wilson, 2010 p. 7).

This ensures that investors will not be charged for a dismal performance and incentivizes the

manager to maximize absolute returns. Hedge funds have historically promised these absolute

returns. In other words, the fund guarantees the investor that they will return a profit regardless

of the market conditions (The Economist, 2012). Absolute returns are another differentiating

factor between hedge funds and other investment vehicles. Another mechanism that is

employed by hedge funds is known as a high-water mark. A high-water mark is essentially an

assurance on the manager’s part to the investors that they will not be charged performance fees

during losses. If the hedge fund incurs losses, then the investors will not be charged until the

manager has made up those losses.

Hedge funds also employ a highly controversial practice known as a gating clause (controversial

due to the rise in the practice of manager’s “closing the gate” or preventing investors from

withdrawing their money entirely). A gating clause enables managers to

“restrict or completely cut off redemptions from the portfolio due to market illiquidity or

specific sets of circumstances set forth in the contract” (Wilson, 2010 p. 8).

In other words, the manager retains the ability to prevent investors from withdrawing their

money from the fund. The purpose of a gating clause is to prevent a massive capital flight that

could cripple the hedge fund or cause it to implode. Gating clauses can be viewed as a necessary

instrument to ensure that redemptions or withdrawals have a limited impact on the liquidity

and value of the hedge fund’s portfolio (Lestz, 2011). Another essential component of hedge

funds is their ability to maximize leverage. Their use of leverage is central to understanding the

functionality of hedge funds. Leverage enables hedge funds to maximize their profits by giving

them the ability to trade in greater volume (Mallaby, 2011a p. 10). In other words, hedge funds

can use borrowed money or sophisticated investment instruments to increase their returns by

enabling them to buy and trade in greater volume. Hedge funds are not as leveraged as

investment banks or other investment vehicles. Sebastian Mallaby notes that

“the average hedge fund borrows only one or two times its investors’ capital, and even those that are

considered highly leveraged generally borrow less than ten times” (Mallaby, 2011a p. 12).



This is partly because managers often have their own capital in the fund and there is no safety

net to bail them out if they get into trouble.

Among the most important innovations of hedge funds that have enabled them to accumulate

enormous profits is the method of combining leverage and short selling. As previously stated, a

fund manager can use leverage to borrow, which in turn enables the manager to trade in greater

volume in long positions (allowing for greater diversification), and he or she can still use some of

the funds to purchase bad short positions, which helps offset his or her total market exposure

(Mallaby, 2011a p. 24). In More Money Than God, Sebastian Mallaby writes,

“the [hedge] fund does better in a bull market despite the lesser risk it has assumed; and the

[hedge] fund does better in a bear market because of the lesser risk it has assumed” (Mallaby,

2011b p. 25).

This flexibility enables hedge funds to see profits in both market types while minimizing the risk

their investors are exposed to. Lastly, it is important to mention two fundamental terms that are

commonly used in hedge fund jargon. These are alpha and beta. Beta is the systematic risk or

volatility of a market or portfolio and alpha is a measurement of performance based on a

benchmark or risk-adjusted basis (Koba, 2012). These serve as important evaluative means to

measure the aggregate performance of hedge funds.

3. ORIGINS OF HEDGE FUNDS Hedge funds can be traced back to 1949 (Johnson, 2007). Their narrative attests to the

entrepreneurial and innovative nature of the industry. Hedge funds have evolved from an

obscure abstract creation of one man to an ever-expanding sector of finance. Today, there are an

estimated 11,000 hedge funds that manage roughly $2.6 trillion in assets (Delevingne, 2014).

The narrative begins in 1949 with an eccentric individual by the name of Alfred Winslow Jones.

Alfred Jones was an author, sociologist, financial journalist for Fortune, and a former vice

counsel in the United States Foreign Service office in Berlin (Russell, 1989). While working for

Fortune, Jones began to explore financial markets and the correlation between returns and

investor psychology (Mallaby, 2011a p. 20). He believed that psychology shaped stock market

trends and the key was to become cognizant of the different factors that contribute to the

emotions that influence investment decisions (Mallaby, 2011a p. 20). By understanding human



psychology, one can analyze market trends to determine whether the market will continue to

rise based on optimism or will contract due to a fear that the market is becoming unstable

(Mallaby, 2011a p. 20). Jones used this belief as a basis for establishing the world’s first hedge

fund and began soliciting investments from his inner circle. His hedge fund was established on

the belief that the key to maximizing profits was to invest in long positions that he believed

would outperform the market and short positions that he believed would underperform. This

limited his market exposure and enhanced his flexibility in volatile markets. Jones’s success was

inconceivable for many in the world of finance. He was achieving what academics and economic

theory posited was impossible: the ability to systematically beat the market. In fact, Sebastian

Mallaby writes,

“by 1968 he had racked up a cumulative return of just under 5,000 percent…” (Mallaby, 2011a, p. 24).

It would take several years for others to catch on to the stunning returns that Jones was

generating and venture into the realm of hedge funds.

The subsequent decades saw an exponential increase in the number of hedge funds and the

formation of more sophisticated investment methods. The stock market crash of 1973-1974 was

a foreboding sign. Theoretically, hedge funds should have been insulated from the turbulent

market and continued to make money. However, many hedge funds had overextended

themselves through excessive borrowing, which resulted in many of them being decimated on

their short and long positions (Loomis, 1970). The economic downturn at the beginning of the

decade and the eventual crash in 1973-1974 wiped out the majority of the world’s hedge funds

(Mallaby, 2011a p. 41). An important legal implication for hedge funds came directly out of this

crash. Namely, the SEC had been considering regulating the sector, but the annihilation of so

many hedge funds convinced the SEC that there was not a need to regulate them (Mallaby, 2011a

p. 41). One hedge fund was able to solidify its place among hedge fund lore during this epoch.

Steinhardt, Fine, Berkowitz & Company (led by the legendary Michael Steinhardt) was able to

survive the crash by balancing their long stocks through shorting their short stocks (Mallaby,

2011a p. 42). Thus, they were able to rely on their intuition and knowledge of the market to ride

out the crash, and remarkably returned 361 percent over the period of the 1960s and 1970s

(Mallaby, 2011a p. 42). Michael Steinhardt became a trading superstar during this time by going

against conventional wisdom. According to Michael Noer of Forbes,



“from 1967 to 1995 his pioneering hedge fund returned an average of 24.5% annually to investors, even

after Steinhardt took 20% of the profits” (Noer, 2014).

This case example of Steinhardt, Fine, Berkowitz & Company illustrates the notion that success

in the hedge fund sector can largely be attributable to betting against conventional wisdom and

intrepidly exploring new mediums of finance.

The remainder of the 20th century saw the continued evolution of hedge funds. The introduction

of computers dramatically redesigned hedge funds and the financial sector as a whole. The

addition of computers for high frequency trading ushered in the “quants.” A hedge fund by the

name of Commodities Corporation was one of the first hedge funds to be founded by these so-

called “quants” (Mallaby, 2011a p. 63). Quants are known for using highly sophisticated

computers and mathematical formulas for trading. In More Money Than God, Sebastian Mallaby

explains that the basic tenets of the Commodities Corporation were to use sophisticated math

and computer models to beat the market (Mallaby, 2011b p. 65). This greatly changed the game

by adding a different dimension into trading. However, many of the hedge funds run by “quants”

soon discovered that their sophisticated mathematical formulas and computer systems could

not account for every variable. In particular, they discounted basic human intuition. Intuition

has the capacity to predict trends and forecasts that computers simply cannot. The rise of

Michael Marcus and Bruce Kovner came to epitomize the development of trend surfing. Trend

surfers systematically monitor the market and various charts to uncover recurring patterns that

can then be capitalized on to make a profit. Lastly, any summation of the origins of hedge funds

would be incomplete without a reference to the iconic George Soros. George Soros used his

philosophical understanding of the world and human nature to become one of the greatest

investors of all time. He developed a general theory of reflexivity to understand the workings of

financial markets and human decision-making. Reflexivity essentially posits that

“investors’ and traders’ biases can change the fundamentals that assist in determining market trends”

(Investopedia, 2012),

but Soros elaborated on this by concluding that a feedback loop exists, which drives both

markets and investors forward until a crash eventually occurs (Soros, 2009). In other words,

Soros concluded that a boom-bust cycle exists between markets and investors, which can be

utilized to maximize one’s profits. His success would have drastic implications on the global



economy and set a precedent for the trajectory of future hedge funds. This will be explored in

depth at a later point in this paper.

4. THE ROLE OF HEDGE FUNDS Hedge funds play a distinct role in the market – specifically capital markets – and influence the

direction of the global economy. The extent of their influence is currently a controversial issue.

Proponents of hedge funds posit that they stabilize the market by providing liquidity and

muscling prices into line whereas opponents posit that hedge funds are inherently destabilizing

and contribute or exacerbate economic downturns (Mallaby, 2011a p. 10). Opponents

fallaciously attribute recessions and other financial difficulties to hedge funds due to their

incognizance. In actuality, hedge funds have historically played a minimal role in economic

crises and have not exacerbated crises to the extent that the media delineates. This is

particularly true in capital markets. Hedge funds facilitate the flow of capital and provide

additional sources of opportunity for investors. This encourages economic development and

innovation. Innovation is a central component of economic stability and growth since it fosters

additional avenues for investment. The capacity of hedge funds extends further than just

economic growth. Hedge funds can also curtail stress in the markets, thus reducing its negative

effects. In a meeting before the Senate subcommittee on Securities, and Investment, Patrick M.

Parkinson elucidates this notion by writing,

“… when the options and other fixed income markets were under stress in the summer of 2003, the

willingness of hedge funds to sell options following a spike in options prices helped restore market

liquidity and limit losses to derivatives dealers and investors in fixed-rate mortgages and mortgage-backed

securities” (Parkinson, 2006).

The flexibility of hedge funds enables them to engage in practices that other investment vehicles

are either unable or unwilling to engage in. This in turn, stabilizes the market and encourages

further investment. The mere fact that hedge funds can theoretically trade and invest in a

multitudinous array of opportunities with minimal regulations enables them to utilize a global

approach to financial markets. In a speech in 2004 at the National Conference on the Securities

Industry, Timothy Geithner substantiates these facets by stating:



“Hedge funds play a valuable arbitrage role in reducing or eliminating mispricing in financial markets.

They are an important source of liquidity, both in periods of calm and stress. They add depth and breadth

to our capital markets. By taking risks that would otherwise have remained on the balance sheets of other

financial institutions, they provide an important source of risk transfer and diversification” (Geithner,

2004).

Although hedge funds control a sizable share of capital, their assets are highly diversified and

most engage in risk management, which reduces the potential for triggering a crisis. The

portfolio diversification provided by hedge funds ensures that the investor’s assets are not as

directly correlated with certain market conditions, thus reducing the risk of sustaining serious

losses. Hedge funds play an essential role in financial markets – in particular capital markets –

by providing liquidity, risk management, innovative solutions and investment opportunities,

and stabilizing market prices, which ultimately facilitates economic growth.

5. THE ECONOMIC EFFECTS OF HEDGE FUNDS IN THE UNITED STATES The economic effects of hedge funds in the United States are ubiquitous. Hedge funds are an

integral component of market competitiveness in the United States and are gradually expanding

their role. The current estimate for the total assets under management is more than $2.4 trillion

(Zakaras, 2012) and American hedge fund managers are frequently referred to as the Masters of

the Universe (Wolfe, 2008). They have reshaped the functionality of finance and the way that

firms derive their profits. For instance, The Economist notes that a sizeable portion of

investment banks’ income now comes from lending and trading for hedge funds (The Economist,

2006). Investment banks and hedge funds are intrinsically linked since they are reliant upon

one another to maximize their profits. In addition, the portfolio diversification offered by hedge

funds is an attractive feature for institutional investors since it reduces the risk that their

portfolios are exposed to. As previously stated, hedge funds also provide an important source of

liquidity to capital markets, which is especially true in the United States. Hedge funds increase

the flexibility in the US market by providing additional liquidity, which has limited the extent of

financial shocks (Hall, 2007). They also frequently force inefficient prices into line, which

reduces the likelihood of market distortions. In a testimony before the House Financial Services

Committee, George E. Hall, the Chief Investment Officer of Clinton Group, stated,



“in targeting temporary price inefficiencies and market dislocations, hedge funds effectively help to

minimize market distortions and eliminate these dislocations” (Hall, 2007).

Chester S. Spatt of the American Enterprise Institute elucidates this by asserting that it is the

diversification in different market sectors that enables hedge funds to ensure the fairness of

pricing (Spatt, 2006). This supplementation of additional liquidity and efficient prices decreases

market volatility.

The expansion of hedge funds in the United States has also generated extensive debate among

central bankers and regulators regarding the systemic risk they pose. It has been concluded that

as a sector, hedge funds do not pose a serious systemic risk to the market. Moreover, only about

400 or 500 hedge funds actually have the ability to create systemic risk in the market (Cantrell,

2005). This is because the majority of hedge funds are too small to generate any market

turbulence, but the collaboration of several of the largest hedge funds could potentially cause

market turbulence and an economic crash. The failure of a major hedge fund could also pose

serious macroeconomic problems. The case of Long-Term Capital Management (LTCM) is an

example. The failure of LTCM in 1998 shocked Wall Street and threatened to upend the entire

financial system. At the time, LTCM was one of the world’s largest hedge funds and was run by

John Meriwether of Salmon Brothers and Myron S. Scholes and Robert C. Merton, winners of

the 1997 Nobel Prize in Economics. The firm was a relative-value fund and engaged in

convergence trading. The firm would take long positions in bond markets that they deemed as

inefficient with the intention that those inefficiencies would ultimately be eliminated by the

market. LTCM also employed an arbitrage strategy

“that could take advantage of temporary changes in market behavior and, theoretically, reduce the risk

level to zero” (McWhinney, 2010).

This in turn, would result in impressive profits for their investors. This strategy was based on

the firm’s combination of Nobel Prize winning academics that could provide innovative

quantitative models to the all-star traders that could then execute these models (Bancware,

2006). Unfortunately, LTCM became highly leveraged when it used derivatives to take

exorbitant positions in volatile Russian bonds (Dungey, 2002). Russia ultimately defaulted and

the firm began losing $300 to $500 million a day (Lowenstein, 2009). LTCM lost $4.5 billion

before the Federal Reserve organized a rescue (Lowenstein, 2009). It ultimately took a $3.6



billion recapitalization to stymie the fund’s bleeding and avert a financial crisis. The case of

LTCM is a cautious anecdote of the implications of being heavily reliant on esoteric quantitative

models and being heavily leveraged without a system of risk management in place. Regulators

and central bankers in the United States frequently refer to the tragic ending of LTCM when

they are evaluating systemic risk and future directives involving hedge funds.

6. “HERDING” AND PSYCHOLOGICAL ATTRIBUTES Psychological attributes and the notion of herding are two unique phenomena that contribute to

the success of hedge fund managers and influence market trends. There are certain

characteristics that many of the top hedge fund managers seem to possess and many believe that

it takes a certain type of person to truly be successful in the industry. The legendary Michael

Steinhardt, believes that contrarians are especially well suited for the industry. When it came to

recruiting employees for Steinhardt, Fine, Berkowitz & Company, Steinhardt specifically looked

for people with strong contrarian views who were decisive and capable of defending their

positions (Mallaby, 2011a p. 47). It appears that contrarianism is omnipresent among hedge

funds because it inherently posits that one goes against the prevailing opinion. With regard to

investing, this means that an investor should go against the prevailing opinion of the market and

go against the current trend. This is an essential component for successful trading since the

investor is capable of capitalizing on profitable opportunities while most people are incognizant.

Accompanied with contrarianism is the ability to remain flexible. Many investors become

attached to certain stocks because they have spent countless hours researching it before taking

their position, but a hedge fund manager must be willing to cut his losses or remain in a position

when others are bailing out. In other words, confidence in one’s personal convictions, discipline,

and intellectual agnosticism are additional characteristics that are highly rated in the industry.

An incredibly high-risk tolerance and a relentless work ethic are often seen as necessary

dispositions to succeed in the industry (Agnew, 2012). A high-risk tolerance is necessary

because the industry is inherently risky and a manager must possess the ability trade on a whim

and take calculated risks that could potentially result in the loss of millions of dollars. Likewise,

a relentless work ethic is necessary because financial markets are globally connected and many

of the preeminent managers continue to trade in the middle of the night or while on their

holidays. It often requires personal sacrifices that many people are unwilling or unable to make.



These facets help explain why very few people make it into the hedge fund industry and why

even fewer succeed as managers.

The phenomenon of herding plays a distinct role in the realm of hedge funds. Herding is a

mentality that is characterized by a group of investors basing their investment decisions on the

belief or action of others. For example, if a prominent investor is shorting his position in a given

stock, then it is likely that many others will follow suit because they do not want to be left out or

caught off guard. It has often been assumed that hedge funds are the driving force behind

herding in financial markets and mere speculation that a hedge fund is going to take a certain

action could result in investors frantically following suit. This would subsequently destabilize

markets and cause massive price swings in prices. However, recent research has discredited this

claim and actually shown that hedge funds herd less frequently and have less portfolio overlap

with one another than other financial institutions (Reca et al., 2012). The authors of the study

found that,

“on average, hedge funds’ trades appear to push prices toward equilibrium whereas non-hedge fund

institutions’ trades push prices away from equilibrium” (Reca et al., 2012).

In other words, hedge fund herding does occur, but to a lesser extent than many had previously

believed. When it does occur, it generally does not destabilize markets or prices (Reca et al.,

2012).

7. THE ROLE OF HEDGE FUNDS IN THE 1997 ASIAN FINANCIAL CRISIS The 1997 Asian Financial Crisis shook the very foundation of the financial system. The crisis

began in Thailand in July 1997 with the devaluation of the Thai baht. The collapse of the baht

and the burden of foreign debt effectively bankrupted the state. The crisis soon disseminated to

other East Asian countries – namely, South Korea, Malaysia, Indonesia, Singapore, and the

Philippines. Foreign debt ratios of these countries increased exponentially, a devaluation of

their respective currencies occurred, and the International Monetary Fund had to intervene to

limit the calamity. Several studies and actors (namely, the former Prime Minister of Malaysia,

Dr. Mahathir Bin) have identified hedge funds as the perpetrators of the currency crisis, but

these accusations need to be seen in the broader perspective. Namely, it is undeniable that

hedge funds were involved in creating the crisis, but their role has often been exaggerated.



The role of hedge funds in the beginning of the crisis can be traced back to George Soros’

Quantum Fund. Stanley Druckenmiller and George Soros realized that a devaluation of the Thai

baht was imminent after their team had met with senior Thai officials (Mallaby, 2011a p. 200).

They immediately shorted $2 billion worth of baht, which could have served as a trigger for

extensive shorting of the currency among other financial institutions (Mallaby, 2011a p. 200).

Rather than devalue its currency, the Thai government immediately started buying baht from

investors (Mallaby, 2011a p. 200). The economic crisis intensified as the government continued

to make injudicious policy decisions. Soros was largely accused for precipitating the crisis by

shorting the baht, but ultimately other actors such as mutual funds, investment banks, and

domestic investors were more actively involved in the baht’s devaluation. A seminal study by

Barry Eichengreen and Donald Mathieson of the IMF concluded that hedge funds were not the

principal actors in the crisis. They estimate that hedge funds were involved in short selling

around $7 billion out of $28 billion worth of baht (Eichengreen, 1999). Their study notes that

“the baht is the only Asian currency for which hedge funds collectively took significant short positions…”

(Eichengreen, 1999).

It has also been identified that the currency volatility caught most hedge funds by surprise and

they were largely removed from the market calamity (Eichengreen, 1999). Thus, many hedge

funds were unable to take short or long positions against the various currencies, equities, and

other assets. Many of those that were in position, were caught off guard by the extent of the

crisis and incurred significant losses from being ill-prepared for the resultant currency

devaluations.

Hedge funds played a minimal role in the overall extent of the crisis because they were miniscule

in comparison to the institutional investors that were actively involved. In “Who Triggered the

Asian Financial Crisis,” Michael R. King writes,

“Hedge fund assets, estimated at up to $150 billion, are dwarfed by other institutional investors such as

pension funds with over $13,000 billion or mutual funds with over $7,000 billion” (King, 2001).

In other words, hedge funds were dwarfed by the larger institutional investors and were

incapable of exacerbating the crisis to the extent that they are often ascribed to. Rather,

commercial and investment banks compounded the contagion and were responsible for the



deleterious macroeconomic effects on the East Asian countries. Hedge funds were involved in

the crisis by taking both long and short positions against various East Asian currencies, but they

cannot be held entirely responsible for the negative implications of their actions. They were

unfortunately blamed for the crisis because the data on their activities existed whereas it was

non-existent for some of the larger institutional actors. The experience of the 1997 Asian

Financial Crisis is a cautionary tale of crises and the propensity to fallaciously ascribe blame to

hedge funds due to them being viewed as exploitative capitalistic vehicles that are utilized by

egomaniacal investors.

8. THE DISRUPTIVE EFFECTS OF HEDGE FUNDS IN EUROPE Hedge funds have primarily been associated with the United States, but they are also an

important part of the financial sector in Europe. Europe is home to some of the world’s largest

hedge funds such as Man Investments, Brevan Howard, and BlueCrest Capital Management.

Globalization has enabled hedge funds to invest in assets from around the world, but this has

also enabled the largest hedge funds to impact countries that they are not domiciled in. This has

most notably occurred in Europe with hedge funds intervening in the currency markets in 1992,

George Soros’ Quantum Fund (Soros Fund Management) destroying the British sterling (also in

1992), and the disruptive implications of Deutsche Börse’s failed takeover of NYSE Euronext.

The actions of hedge funds in the 1990s would drastically alter the relationship between

governments and markets due to globalization, interconnected financial system, and the

dissemination of information regarding the intentions of central banks.

The actions of hedge funds in 1992 and the subsequent decades is a result of the interconnection

between politics and economics. The policies of governments heavily influence the trajectory of

the market and vice versa. The European political landscape of the late 1980s and early 1990s

was dominated by the European Currency Unit (ECU) and the proposition of creating the Euro.

The antipathy to the various regional differences – most notably, the central banks’ ideological

differences among one another – enabled hedge funds such as the Quantum Fund and the

Commodities Corporation to capitalize on the disarray. The reunification of Germany resulted

in the Bundesbank becoming the anchor for both the deutsche mark and Europe’s exchange-rate

mechanism (ERM) (Mallaby, 2011a p. 152). The high interest rates in Germany in the 1990s

resulted in a sudden influx of investments into the deutsche mark, which drastically altered the



functionality of the ERM (Mallaby, 2011a p. 152). The influx of investments into the deutsche

mark meant that the currencies of countries with lower interest rates such as Italy, France, and

Great Britain were trading toward the bottom of the ERM while Germany was trading at the top

(Mallaby, 2011a p. 152). This robbed these countries of much needed capital and set the stage for

the devaluation and ejection of several of their currencies from the ERM. More importantly,

Britain’s fall to the bottom of the ERM meant that the Bank of England would be obligated to

intervene and purchase an unlimited amount of pounds as traders continued to sell them off

(Drobny, 2006 p. 14).

The President of the Bundesbank, Helmut Schlesinger, refused to modify Germany’s monetary

policy or adjust interest rates, which essentially threw several European countries to the wolves.

The British government was opposed to higher interest rates, thus sealing the state’s fate for the

devaluation of the sterling or a recession (Mallaby, 2011a p. 159). Various hedge funds began

mobilizing by purchasing weaker currencies before ultimately going on the attack. In More

Money Than God, Sebastian Mallaby states,

“on Tuesday, September 8, the day that Schlesinger declared he could make no promises on German

interest rates, a wave of speculative selling overpowered the Finnish central bank, forcing the government

to abandon its peg to the ECU…” (Mallaby, 2011b p. 159).

This was just the beginning of the onslaught. Three days later, a wave of speculative selling

struck the Italian lira resulting in its ejection from the ERM and its devaluation (Sevilla, 1995).

The devaluation of the lira should have served as a forewarning to the British government that

the sterling was at risk for a similar fate. The only defensive measure that the Bank of England

took was to borrow £7.5 billion so that it could continue to purchase sterling to fend off

additional attacks by hedge funds (Mallaby, 2011a p. 159). Unfortunately, this was to little avail.

It became clear that the Bundesbank was disinterested in continuing to bail out its monetarily

weaker neighbors and saw no need to cut interest rates. George Soros’ Quantum Fund began

shorting its position in sterling, which triggered massive selling throughout the world. On

September 16, 1992, the British government decided to withdraw from the ERM and the pound

subsequently fell 15 percent against the deutsche mark (Drobny, 2006 p. 15). The Quantum

Fund netted several billion dollars from shorting the pound and George Soros was given the

moniker,



“the man who broke the Bank of England” (Drobny, 2006 p. 15).

The repercussions of this were immense. Governments immediately called for the regulation of

hedge funds and central bankers stood in disbelief. How could a hedge fund cause such

catastrophic consequences? The interconnectivity of the financial markets and George Soros’

clout enabled him to capitalize on his vast position in pounds, which resulted in a trickle down

effect. This encouraged other traders to short their positions and the British government’s ill-

advised decision to continue to buy pounds resulted in taxpayers footing the bill for the several

billion dollars that the Bank of England squandered.

The ability for hedge funds to amass prodigious returns and effect sociopolitical and geopolitical

outcomes is well documented. However, hedge funds also have the ability to derail mergers and

other sophisticated deals. This is commonly referred to in the vernacular as shareholder

activism. Europe witnessed several surprising instances of shareholder activism by a little

known hedge fund called The Children’s Investment Fund Management (TCI) led by Sir Chris

Hohn. In 2012, Deutsche Börse, the operator of the Frankfurt Stock Exchange and a leading

exchange organization that provides investors with access to global markets through trading,

was in negotiations to merge with NYSE Euronext, a global equities exchange. The merger

would have created one of the largest organizations for global derivatives trading. Philip

Stafford of the Financial Times elaborates on this by writing,

“the merger would have created a powerhouse, representing more than 95 per cent of Europe’s trading

and clearing in benchmark exchange-traded derivatives” (Stafford, 2012).

Thus, the merger would have created a substantial platform for the high-volume trading of

derivatives and enhanced the efficacy of the business. The consolidation would have arguably

increased competition and stimulated markets. The European Commission along with hedge

funds called upon shareholders to reject the proposal, which effectively killed the deal.

Deutsche Börse sought to purchase the London Stock Exchange (LSE) in 2005 and TCI

management helped derail that deal as well by acting in the shareholders interests by publically

renouncing the acquisition and calling upon the shareholders to replace the entire supervisory

board at Deutsche Börse. The ability for hedge funds to act in the interest of shareholders is

diametrically opposed to the traditional belief that hedge funds are only out to maximize their

profits. TCI and the other hedge funds might have disrupted global stock markets by killing the



deals, but they were operating under the notion that the shareholders should have been given a

better deal. The experiences involving hedge funds in Europe have dramatically changed the

political opinion in several countries regarding their regulation.

9. THE ROLE OF HEDGE FUNDS IN THE 2007-2009 FINANCIAL CRISIS Academics, central bankers, and regulators have debated the role of hedge funds in the 2007-

2009 financial crisis extensively. The media and other commentators fallaciously identified

hedge funds as playing a central role in precipitating the crisis. However, subsequent studies

have concluded that hedge funds did not precipitate the crisis and the extent of their role has

largely been over-exaggerated. It is undeniable that hedge funds were involved in the crisis and

arguably exacerbated certain facets of it, but they were not responsible for triggering the crisis.

One of the common arguments expounded by hedge funds is that they cannot be held liable for

any of the losses incurred during the crisis because they did not provide the collateralized debt

obligations, credit default swaps, and synthetic collateralized debt obligations, which

contributed to the subprime bubble. Another commonly used argument is that they did not

create the toxic securities that were passed off as safe investments by credit rating agencies

(Lysandrou, 2012). Both of these arguments are valid to a certain extent. Investment banks,

mortgage lenders, credit rating agencies, issuers of credit default swaps, and other global

financial services firms were responsible for packaging and selling these various derivatives and

other sophisticated financial instruments to ingenuous investors and institutions. These

entities were the real culprits, not hedge funds. However, hedge funds did actively engage in the

purchasing and selling of these various credit derivatives and other instruments. Lloyd Dixon, a

senior economist at RAND, writes:

“In contrast to banks, which invested heavily in subprime mortgages, hedge funds invested on both sides

of the market. By betting that assets based on subprime mortgages and the banks that invested in them

would decline in value, hedge funds called attention to the growing bubble” (Dixon, 2012).

In other words, hedge funds were clearly not the precipitating actors in the crisis. Many hedge

funds were ill-equipped for the crisis and were either bankrupt or lost billions of dollars. For

example, two Bear Stearns hedge funds went bankrupt at the beginning of the crisis because they

were highly leveraged and had taken ill-advised positions in the housing market.



Nevertheless, hedge funds did contribute to the crisis by taking certain actions. It exacerbated

the financial crisis by short-selling various assets and withdrawing liquidity from the market.

Lloyd Dixon elucidates this by writing,

“hedge funds destabilized financial markets by withdrawing billions of dollars from prime brokers and

their parent investment banks out of fear that those assets could be frozen if the banks declared

bankruptcy…” (Dixon, 2012).

These measures were primarily defensive in nature to protect the funds and their investors from

incurring enormous losses. Unfortunately, it also exacerbated the crisis by withdrawing billions

of dollars of crucial liquidity from the market. Central bankers eventually intervened in many

states by prohibiting short-selling, which mitigated its pervasiveness to a certain extent

(Strömqvist, 2009). The High-Level Group on Financial Supervision in the EU also

substantiates the notion that hedge funds played a minimal role in the precipitation of the crisis

and were primarily engaged in the crisis through transmission functions of withdrawing

liquidity and short-selling of stocks and transactions (The European Commission, 2009). Hedge

funds do not play a central role in financial markets, and thus the majority of them are too small

to seriously threaten the financial system (Mallaby, 2011a p. 12). The extent of the systemic risk

that hedge funds pose to the market remains a highly contested issue, but the experience of the

2007-2009 financial crisis is an exemplary lesson of the deleterious risks associated with being

highly leveraged.

10. GERMANY AND FRANCE LEAD THE CHARGE TO HEAVILY REGULATE HEDGE FUNDS IN THE EU The European experience of the 2007-2009 global financial crisis accompanied with the

experience of the exchange-rate mechanism crisis in the 1990s has resulted in the desire to

heavily regulate the industry. Germany and France in particular have led the charge to regulate

hedge funds throughout the European Union. The United Kingdom is antipathetic to the

regulations since it is home to four out of five hedge funds in Europe (Quaglia, 2009). Heavily

regulating the industry would have detrimental consequences for the British economy such as

inducing capital flight. It is also conceivable that the regulation of hedge funds would have

broader implications for the continent as a whole. Hedge funds could circumvent the regulations

by merely becoming domiciled in offshore jurisdictions such as the Cayman Islands or British

Virgin Islands, which some have already done. The basis for imposing stricter regulations on the



industry is based on the experiences of hedge funds in the European market as well as a

misunderstanding of the extent of their actions. Lucia Quaglia writes,

“episodes such as the failed merger between the Deutsche Börse and the London Stock Exchange brought

to the fore the potential disruptive effects that hedge funds can have on corporate governance in

continental European countries…” (Quaglia, 2009).

The directive aimed at imposing stricter regulations on hedge funds came into effect in 2013, but

it is important to understand the basis for why countries such as France and Germany were

eager to institute fresh regulations.

There are multitudinous explanations given for why regulations are necessary. However, many

of them lack substantive statistical or economic data to corroborate the need for them.

Moreover, the desire to regulate hedge funds has become politically polarized in Germany and

France. The Social Democratic Party and Christian Democratic Union have frequently criticized

the transparency of hedge funds and popular opinion has taken a xenophobic undertone against

British and American hedge funds. Mark Landler of The New York Times writes,

“party leaders have tarred foreigners as ‘locusts’ who plunder German companies and throw out their

workers” (Landler, 2005).

This viewpoint is largely a byproduct of Deutsche Börse’s stymied acquisition of the London

Stock Exchange by hedge funds, which had a ripple effect across the German economy. Germany

has been able to garner the support of France with its push for enhanced regulatory measures

largely because public opinion is in support of it. Central bankers and regulators have been

propagating the notion that hedge funds induce systemic risk in markets, and thus regulation is

necessary to reduce market volatility. It is understandable that Europe has witnessed a backlash

against hedge funds after its perceived negative experiences with them, but it is misguided to

reduce the efficacy of capital markets and market liquidity by imposing stricter regulatory

measures that will reduce their flexibility, cause capital flight, and stymie innovation.

11. THE ALTERNATIVE INVESTMENT FUND MANAGERS DIRECTIVE (AIFMD) The Alternative Investment Fund Managers Directive (AIFMD) is a European Union directive

with the objective of creating a comprehensive regulatory framework to enhance the



transparency and reduce the systemic risk of hedge funds (among other types of investment

vehicles) (The European Commission, 2014). It went into effect in 2013 and requires all EU

states to comply with its measures. The directive applies to a variety of investment vehicles such

as private equity funds, but this discussion will solely focus on its applicability to hedge funds.

The proposal was initially adamantly opposed by the United Kingdom until the government

realized that it would have been injudicious to spend a considerable amount of money fighting

the directive when it was guaranteed to pass. The basis for the AIFMD is to stabilize the

financial market, create a universal platform to regulate hedge funds through supervisory

measures, and protect investors from market volatility and exploitative investment schemes.

The directive will require hedge funds to become more transparent and compliant through four

distinct measures. However, hedge funds with assets under management of €100 million or less

will not be required to comply with the directive (Govier, 2013). Hedge funds will be required to

appoint a depository, create a comprehensive system of risk management to minimize losses and

protect investors, disclosure of remunerations, and enhanced transparency and accountability

through annual reports to investors and quarterly reports to regulatory bodies.

PricewaterhouseCoopers elucidates some of the impacts that the AIFMD will have on hedge

fund managers in a comprehensive brochure. They state that some hedge funds will be unable to

institute the mandated system of risk management because they do not have the necessary

financial resources and the additional red tape will impose unnecessary costs on hedge funds

while reducing their flexibility to engage financial markets (Pricewaterhousecoopers, 2012).

The directive applies to all hedge funds that are trading, operating, or conducting business

throughout the European Union. According to Preqin, the industry leader in intelligence and

data, 48 percent of European (excluding the UK) fund managers are in compliance with the

directive and only 43 percent of UK managers are in compliance (Preqin, 2014). The cost of

implementation has also been significantly higher than many had expected, costing most hedge

funds about $300,000 to fully comply with the directive’s measures (Preqin, 2014). The

substantial cost of compliance has deterred many from fully implementing the directive’s

measures and registering with regulators. The directive will have a detrimental impact on

European economies since 40 percent of US based hedge funds and 27 percent of non-European

hedge funds have stated that they will not actively market themselves in the European Union

(Preqin, 2014). The loss of capital from foreign investors and hedge funds will reduce the

competiveness in European capital markets and an exodus of European based hedge funds could



hinder the economies of countries such as the United Kingdom where most European hedge

funds are based. It is an erroneous assumption by central bankers and regulators to believe that

the AIFMD will produce any substantial benefits and it appears that they have taken a

shortsighted view of the economic extent of hedge funds for political purposes rather than sound

economic data.

12. EFFECTIVENESS OF OTHER REGULATIONS AND THE BROADER IMPLICATIONS FOR THE GLOBAL

ECONOMY It is too early to make a definite conclusion about the efficacy of the various regulatory measures

since they have not had ample time to be in effect for. However, it is important to understand

some of the measures that have come into effect since the global financial crisis of 2007-2009.

The United States and several Asian countries have instituted supervisory and regulatory

measures to increase the transparency and oversight of hedge funds. However, the extent of

regulations is significantly less stringent than the measures that have been implemented in the

European Union. In the United States, the Dodd-Frank Wall Street Reform and Consumer

Protection Act (Dodd-Frank) was signed into law in 2010. The act is intended to stabilize the

financial market by addressing deficiencies that were responsible for the financial crisis and also

includes measures that are specifically geared toward hedge funds. Under the new provisions, all

hedge fund managers with $100 million or more in total assets under management are now

required to register with the Securities Exchange Commission (SEC) and all must file

information regarding their systemic risk with the SEC and CFTC (Managed Funds Association,

2014a). This is aimed at providing better oversight over the larger hedge funds and to enhance

their transparency for investors. The Frank-Dodd Reform also constructed a new regulatory

regime called the Commodity Futures Trading Commission (CFTC), which specifically deals

with the derivatives market. One of its functions is to oversee security-based swaps and banks

and insurance companies that trade over-the-counter derivatives to hedge funds are now

required to register with the SEC and be subject to regulation (Managed Funds Association,

2014b). This is supposed to further minimize the risk and volatility associated with hedge funds.

The majority of the Asian countries that have implemented regulatory and supervisory

measures for hedge funds have sought to enhance the transparency of the industry by requiring

them to register with a governmental agency or regulatory body. However, several states have

also expanded upon this to incorporate some of their practices as well. In Hong Kong, the



Securities and Futures Commission (SFC) now requires all hedge funds (funds and individuals

as well) to disclose their short positions on a net basis (SFC, 2011). Taiwan and India have both

proposed to tax hedge funds at a higher percentage than they had previously done. As previously

stated, central bankers and regulators view all of these measures as a way to reduce systemic

risk.

The effectiveness of these measures remains to be seen along with their broader implications for

the global economy. However, the basis for these measures following the 2007-2009 financial

crisis is to stabilize financial markets and reduce systemic risk. Regulatory and supervisory

measures to increase transparency and accountability are important to provide protection to

investors and minimize the tremors from the largest hedge funds. It is important to note that

most of these measures only apply to the largest hedge funds and do not create an abundance of

regulatory tape. Hedge funds have continued to accumulate impressive returns, and thus it can

be inferred that the regulatory measures taken in the United States and Asia have not had the

detrimental impact that many anticipated.

13. CONCLUSION Hedge funds have gradually evolved since their inception by Alfred Winslow Jones in 1949.

Their innovative trading techniques have become pioneering mediums for finance and

investing. The industry remains shrouded in secrecy and the very notion of hedge funds and

their managers evokes a veneration that has not been witnessed before. The media’s infatuation

with hedge funds has propagated various fallacies and misconceptions about their structural and

functional basis. Hedge funds play an important role in markets – in particular, capital markets

– by stabilizing inefficient prices, providing liquidity, and absorbing risk. These characteristics

are especially true in the United States where the majority of hedge funds are based. The

experience of Long-Term Capital Management in the United States and the 1997 Asian Financial

Crisis have served as invaluable lessons for the repercussions of being highly leveraged and have

furthered our understanding of hedge funds and their systemic risk. Additionally, the disruptive

effects of hedge funds such as the Quantum Fund in Europe have demonstrated the resultant

interconnectivity between governments and markets that have occurred from globalization. It

has been concluded that hedge funds did not precipitate the 2007-2009 financial crisis, but did

play a role during the crisis. However, this role was primarily confined to withdrawing liquidity



from the market and excessive short-selling of assets. Unfortunately, the aftermath of the crisis

witnessed an unprecedented rise in the desire to heavily regulate the industry. Germany and

France led the charge in Europe to heavily regulate the industry through the proposition and

passage of the Alternative Investment Fund Managers Directive. The efficacy of the AIFMD and

regulatory measures taken by other countries remains to be seen. However, these measures

have raised a multitude of concerns regarding the detrimental impact on the industry as a whole

from the additional red tape and other legal restrictions that threaten to stymie the various

tenets that are responsible for their success.

It is imprudent to heavily regulate hedge funds following the 2007-2009 financial crisis. The

financial contagion was precipitated by credit rating agencies, investment banks, mortgage

lenders, and other financial institutions that specialized in engineering and promulgating

collateralized debt obligations, credit default swaps, synthetic collateralized debt obligations,

and other toxic investment instruments. Regulations were supposedly in place to stabilize the

market and prevent such risky behavior. If the regulations that were supposed to create a safety

net and prevent an implosion of the financial sector failed once, what is to stop them from failing

again? In other words, regulations have proved to be fallible and restricting the ability of hedge

funds to function effectively is injudicious. The proliferation of hedge funds and similar

investment vehicles will enhance the viability of markets, strengthen economic development,

create jobs, and spur innovation. Governments should encourage this and not attempt to

constrain them with gratuitous regulatory measures. The failure of hedge funds has never

required taxpayer dollars to bail them out (Mallaby, 2011a p. 376). As Sebastian Mallaby notes, it

is inevitable that there will be some hedge funds that will prove too big to fail (Mallaby, 2011a p.

12). The focus of regulatory measures should be devised with a limited extent to prevent the

failure of a major hedge fund from triggering a crisis. This will prove both conducive to

diminishing systemic risk and cost effective for the private sector and governments. Thus, the

excessive regulation of hedge funds is unnecessary and could ultimately prove detrimental to the

global financial system by sabotaging the viability of an entire industry.



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